Institutional Capital: Money To Grow On

Institutional capital can help you create significant long-term value you might not have achieved otherwise.

Columns Post: 8/19/2008

Matthew J. Miller

Small- and middle-market companies have many promising growth opportunities, despite the clouds hovering over today’s economy. Organizations can still find financing to fund expansion, a capital investment or an acquisition. But what’s a business owner to do once his or her company’s credit lines have run out?

Institutional capital, which includes subordinated debt and preferred equity (also known as mezzanine capital), could be the answer. It can be used for making acquisitions, buying out partners or obtaining working capital. If your partner wants to retire, but you want to keep working and realize the economic benefits of the growth opportunities you see going forward, mezzanine financing could fund the transaction at a fair valuation and enable you to acquire a larger share of the company. Similarly, if you and your partner want to "take some money off the table," you can do so without giving up control. The right institutional partner will also provide access to capital for future needs, management expertise, and in some cases, industry contacts.

Let’s look more closely at a few common scenarios that are a good fit. Let’s say your company has been growing quickly for the last several years, and you expect this trend to continue. You want to keep working and realize the economic benefits of the growth opportunities you see going forward and the higher valuation your company is likely to command in a few years; however, your partner wants to retire. Mezzanine financing could help you buy out your partner at a fair valuation, and at the same time enable you to acquire a larger share of the company and maintain or gain control of the company.

Similarly, say you and your partner have a solid track record and your future prospects look bright. You both want to keep working, but most or all of your net worth is tied up in the company. Consequently, you and your partner would like to diversify your assets or "take some money off the table." You can do so through a leveraged recapitalization. With this scenario, the company borrows money to pay you a large dividend or repurchase shares. You don’t give up any control, and you get a chance to take a "second bite of the apple."

Institutional capital is an unsecured debt that is subordinated to a company’s senior bank debt. It can be supplied by insurance companies and pension fund providers or funds that pool capital from institutions and high net worth individuals. It is generally used to fulfill long-term capital needs. Also, redemption or amortization usually doesn’t happen until 5 to 7 years after the debt is issued. In exchange for taking a bigger risk than secured lenders, institutional investors assume minority ownership positions in a company and become investment partners. It comes with a higher interest rate—typically between 10 to 14 percent. Preferred equity normally carries a dividend yield of 6 to 10 percent.

Who Qualifies For Institutional Capital?

Your business is a good candidate for institutional capital if you need at least $3 million in funding, have annual sales of at least $10 million and earnings before interest, taxes and depreciation (EBITDA) of at least $2 million.

Institutional investors are looking for companies with a diversified customer base, favorable industry growth trends and barriers to entry—or more simply put, a solid foundation and a bright future. They want to see audited financial statements that show a stable earnings record. They also want minority equity holder rights such as dilution protection, board observation/voting privileges and limited consultation and consent rights. To be an investment candidate, your business should have information systems that can generate quick, accurate financial statements. Finally, investors want to see managerial depth, including a succession plan that ensures smooth operational continuity.

Matchmakers Can Make It Happen

Because institutional investors—like the companies that seek institutional capital—come in many different shapes and sizes, an intermediary usually brings the two parties together. It’s much like an arranged marriage in which the parties meet beforehand to see whether they get along before a union is finalized. Many intermediaries have access to myriad investor groups, allowing companies to determine the best fit.

The intermediary spends time with the capital-seeking company to learn about its needs, observe its business operations and prepare a comprehensive memorandum, which becomes a marketing tool for prospective investors. Then, the intermediary contacts investors it believes best suit the company’s circumstances. The two parties meet and decide whether a business relationship is viable. When the match is made, the intermediary helps negotiate agreement terms and conditions.

Proceed With Caution

Institutional capital can be an excellent way for you to buy out partners, take some money off the table or for your company to expand or make an acquisition. But before pursuing this financing route, thoughtful analysis is necessary. Taking on an investment partner will affect your company’s operations and goals. Institutional capital isn’t simply about the money.

On the plus side, institutional capital can help you create significant long-term value you might not have achieved otherwise. Getting the best deal means putting your company’s investment considerations in the best possible light. A key step in securing institutional capital is a high-quality offering memorandum that highlights your company’s opportunities and strengths. An intermediary can help you prepare and contact investors best suited to your company’s circumstances, so choose this advisor wisely.

Matthew J. Miller is a managing director at BlueWater Partners, a middle market investment-banking firm. As strategic advisors to business owners and management, BlueWater Partners works with companies to create, manage and realize business value, frequently before or during a sale or acquisition. BlueWater Partners’ services include advice on mergers and acquisitions, divestitures, capital sourcing, performance improvement, restructuring and turnaround. Mr. Miller can be contacted at matt@bluewaterpartners.com.